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A construction lender sued a title insurance company seeking defense and indemnification in connection with claims in a developer’s bankruptcy. The district court found that the title company had a duty to defend but no duty to indemnify. The lender appealed the ruling on the duty to indemnify to the 7th Circuit.

The plan was to fund the project with a $32 million equity investment by the developer ($12 million in land and $20 million in cash) and an $86 million construction loan secured by the project. The lender obtained a mortgagee title insurance policy, and the title company was designated as the disbursement agent for the loan.

It soon became apparent that the project was in trouble. The loan was out of balance beginning shortly after the project started, giving the lender a right to stop funding. At the time the issues first came to light, the lender had funded only $5 million out of the $86 million loan. By the time the project fell apart, it had funded more than $61 million.

The general contractor filed a $12 million lien, various subcontractors filed additional liens and the developer filed bankruptcy. The court allowed $17 million in mechanics liens with priority over the mortgage loan. An auction of the property brought only $10 million. When the dust settled, the lender recovered $150,000 on a $61 million claim.

The lender had tendered defense of the mortgage priority to the title company. It rejected the tender based on exclusion 3(a) in the title policy regarding claims “created” or “suffered” by the insured on the basis that the lender created the liens by cutting off funding. The 7th Circuit characterized this as “the most litigated provision in the standard-form title-insurance policy purchased by real-estate lenders to protect their security interests in ongoing construction projects.”

After removal of the lender’s state court complaint against the title insurance company to the district court, the district court found that the title company had a duty to defend, but that it was not required to indemnify based on exclusion 3(a) in the title policy. Thus the key question was whether the exclusion for liens that are “created, suffered, assumed or agreed to” by the insured applied to these circumstances. The court commented that it could not apply any time a construction lender could have prevented a mechanic’s lien since it can always prevent a lien by just paying the contractor’s claim. However, “the exclusion must mean something, so most courts imply a fault requirements.”

Since the liens in this case related to work that was outstanding and remained unpaid when the lender ceased funding, the liens were a direct result of the lender’s action in the sense that it caused there to be insufficient funds. The lender argued that it could not be at fault since it was entitled to stop disbursing by contract. However, the court noted that this did not address whether the lender had a duty to the title insurance company (as opposed to the borrower) to supply funds. In addition, if it either caused the overruns or had control over when the project was halted it could be considered at fault.

The court focused on which party bore the risk of liens when the lender ceased funding as the result of cost overruns. It noted five circuit court cases that considered this issue:

Two circuits (8th and 10th) hold that if the lender cuts off funding, it “creates” or “suffers” any liens resulting from insufficient funds so that exclusion 3(a) applies. This would be the case even though the lender had a right to cease fund. In their view the parties contemplated that the lender would provide adequate funds, and a lack of funding was not the type of risk that a title company was responsible for. Otherwise, in effect the title company would become a guarantor of payment for all work performed.

Three other cases came to a different result. Of those cases from two circuits (6th and 8th) drew the distinction that the lender had fully disbursed its initial loan commitment. Thus, the shortfall was beyond the control of the lender.

The fifth case was a 7th Circuit case that found in favor of the lender. The court distinguished that case for several reasons – including (1) the fact that the duty to defend is broader than the duty to indemnify, and (2) in the 7th Circuit case the mortgage clearly had priority over the mechanics liens, which meant that there was no implied duty to fund since it didn’t make sense to require the lender to pay off junior liens.

The lender in this case argued that it was closer to the fully disbursed fact pattern. Its loan commitment was limited to the lesser of $86 million, 80% of the appraised value of the property, and 75% of the total costs. It claimed that $61 million was more than 80% of the appraised value. However, it did not provide any appraisal to support that argument.

The lender also argued that it was showing good faith in trying to save the project by continuing to fund. The court’s response: “Perhaps. An alternative interpretation is that its poor business judgment precipitated the liens.”

In any event, the court saw this as illustrating the flaw in the reasoning of the 6th and 8th Circuits that drew the distinction based on fully funding. A construction lender typically has broad authority to assess and monitor a project. It could choose to take steps to address a problem as soon as issues appear. For example, it could require the developer to contribute additional cash as a condition of continuing to fund. In this case, if the lender had tried to force the issue at the first signs of trouble its losses would have been less than $5 million, and in the court’s view more likely zero since the land alone was worth ~$12 million.

Trying to use title insurance to cover the costs while the lender retains any benefit from continuing to fund additional work that may add value provides a windfall to the lender and shifts a business risk to the title insurance company. Thus the court concluded that the better interpretation was that: “When liens arise from insufficient funds, the insured lender has ‘created’ them by failing to discover and prevent cost overruns – either at the beginning of the project or later.” That still leaves coverage for liens arising from other causes, such as failure in the payment process or improper disbursement of loan proceeds.

The court also noted that there was an option to obtain coverage: “One way to do so is to purchase the so-called ‘Seattle endorsement’ – basically, a promise from the title company not to invoke Exclusion 3(a) for liens arising from insufficient funds.”

Mechanics liens are a major headache for title insurance companies. They can certainly be expected to take advantage of decisions such as this one. When a project looks like it is getting into trouble, a lender will need to carefully consider its strategy, and should not blindly rely on the availability of title insurance to solve the problem of mechanics liens.

Compare jurisdictions: Arbitration

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